What it means
A healthy bank has assets, mostly loans and securities, worth more than its liabilities, mostly customer deposits and borrowings. The difference is its capital, which absorbs losses.
When bad loans pile up, losses can wipe out the capital, leaving the bank with negative net worth. Normally, such a bank would be closed, sold or restructured.
A zombie bank survives because regulators or governments delay the reckoning, perhaps to avoid panic, protect depositors or avoid the cost of a rescue. The bank may rely on central bank funding, guarantees or relaxed accounting rules.
The problem is what a zombie bank does with its limited resources. It tends to keep lending to weak borrowers to avoid recognising losses, a practice known as evergreening.
It also tends to lend less to healthy new businesses, since it is short of capital, so credit to the real economy dries up. For companies, the effect is felt through the availability of finance.
A business may find that its bank refuses to extend credit, or that it is offered only on harsh terms, even though the business is sound. Weak competitors that should have failed can also survive on cheap credit from the zombie bank, which holds down prices and profits across an industry.
Resolution usually requires recognising the losses and recapitalising the bank with new money, merging it with a stronger bank or closing it in an orderly way. Different countries have used different approaches, with mixed results.
The earlier the problem is dealt with, the lower the eventual cost tends to be. Companies can protect themselves by watching for warning signs.
Sudden changes in lending terms, delays in approving routine facilities and falling credit ratings for the bank are all worth noting. Treasurers often spread their deposits and credit lines across several banks, so no single institution's weakness can freeze the business.
In practice
Real-world examples.
Example
A regional bank carries property loans at full value, although the properties are worth much less. When an inspector revalues them, the bank's net worth turns negative. The government guarantees its deposits while it decides whether to rescue it.
Example
A small manufacturer asks its bank for a $2,000,000 loan to buy new machinery. The bank, short of capital, declines even though the project is profitable. The owner finds another lender at a higher price.
Example
A struggling retailer survives for years on loans that its bank keeps rolling over. The bank avoids calling the loan because writing it off would deepen its own losses, so the retailer stays alive but cannot fund new stock or stores. When the bank is finally recapitalised, the retailer is forced to restructure.
Formula
Calculation
Net worth = Total assets - Total liabilities
Capital ratio = Net worth / Total assets
A bank reports assets of $950 million, after writing down bad loans to realistic values, and liabilities of $1,000 million. Net worth is 950 - 1,000 = -$50 million. The capital ratio is -50 / 950 = about -5.3%. A healthy bank might hold a positive ratio of several percent, so this bank would need at least $50 million plus a buffer to be viable again.Case study
Seen in the real world.
Tessel National Bank is an illustrative, fictional lender with assets of $20 billion. After a property downturn, an independent review finds that $2.4 billion of its loans are unlikely to be repaid, which exceeds the bank's $1.8 billion of capital. Net worth is therefore 1.8 - 2.4 = -$0.6 billion.
Regulators decide not to close the bank immediately, for fear of a run on deposits. The bank is allowed to operate with central bank support. It stops lending to new customers and keeps rolling over loans to troubled borrowers.
After three years of weak lending in the region, the government recapitalises the bank with $1.5 billion and replaces the management. The illustrative lesson is that delay did not remove the losses. It spread them across the economy and made the final cost larger.
Watch out
Common mistakes.
- Assuming a zombie bank has closed, when it continues to operate and serve customers.
- Thinking its accounts show the true position, when loans may be carried at values that hide losses.
- Ignoring the effect on healthy businesses, when a zombie bank's weak lending can restrict credit across a whole economy.
Questions
People also ask.
Are deposits at a zombie bank safe?
That depends on the country's deposit protection and on government support, which is why the rules and limits should be understood.
What is evergreening?
It is extending or refinancing loans to weak borrowers so they do not appear in default, which hides the bank's losses.
How does a zombie bank get fixed?
By recognising losses, adding new capital, merging with a stronger bank or closing it in an orderly way.
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